Without Government the Market Fails and Fails Badly

In a previous post, we discussed some of the evidence suggesting that technology is indeed endogenous and does respond to scarcities and prices.

Many economists have worked on modeling this type of endogeneity of technology and how it responds to prices. Remember the great economist John Hicks’s assertion, which we quoted in our previous post, about how higher price of a factor will tend to induce technological changes directed at economizing on that factor.

Hicks was not the only major figure to think about these issues. Charles Kennedy, Paul Samuelson, and Drandakis and Edmund Phelps all weighed in the 1960s with various theoretical models. But in the age before micro-founded models of endogenous technology based on monopolistic competition, they faced a major challenge: how to model technological progress.

(The technical, but also conceptual, problem was this: If the production function of firms exhibited constant returns to scale in capital and labor, then they would have increasing returns to scale with technology being chosen by firms also, and this would make price-taking behavior impossible).

Work by Daron as well as Michael Kiley developed simple models of directed technological change building on the theories of endogenous technological change.

These models turned out to be not just tractable but also quite surprising in some aspects. In particular, as this paper shows, the implications are quite robust but also different from those that Hicks and others conjectured. But this is a topic for another time.

For our focus here, what is more important is the application of these ideas to the issues of resource scarcities and other environmental implications, which were studied in work by Daron, Philippe Aghion, Leonardo Bursztyn and David Hemous. This work does shed quite a different light on the debate between Ehrlich and Simon.

Recall Simon’s most important point: technology will endogenously respond to scarcities.

One of the results in this research provides a clear support for this line of reasoning: if oil gets scarcer over time, then technology will endogenously switch to cleaner sources of energy, reducing our dependence on oil.

So far so good.

But things are not really as rosy as Simon’s view would suggest.

The real problem isn’t the world running out of oil, but the world frying itself with all sorts of fossil fuels — not just oil but also coal. And coal doesn’t look like it will run out anytime soon.

More specifically, as production using fossil-fuel-based energy creates climate change, economic growth can indeed bring the downfall of the world as we know it (though the exact extent of this does depend on how the world will adjust to significant increases in average temperatures and the variability of climate, on which there is some debate).

In the process some sources of energy may become scarcer, but provided that there are other sources of “dirty” energy, such as coal, this won’t change the trajectory of fossil fuel consumption and climate change.

This research and a complementary paper by Daron, Ufuk Akcigit, Doug Hanley and Bill Kerr suggests that directed technological change may actually make things worse. To start with, dirty technologies are more advanced than clean technologies based on wind, solar power or geothermal (and even, more controversially, nuclear power). Given this state, directed technological change implies that private incentives will encourage firms and researchers to invest more in using and improving these dirty technologies — clean technologies are just too far behind and won’t be competitive, so it wouldn’t make private sense for people to invest much in them.

But in fact, the most important lesson of this work might be a perspective that brings Ehrlich and Simon together. Though the market without intervention fails and fails badly (think environmental disaster), government intervention can be hugely powerful because it leverages the endogeneity of technology and, as Simon posited, the power of the market to generate new technologies.

If the government intervenes and subsidizes clean research, then this can powerfully stave off an environmental disaster. That intervention is necessary comes from the fact that the market, by itself, will not internalize the negative impact it’s creating on the environment (and on future generations).

This is much more powerful than one might have imagined because of an interesting reasoning. Once the government intervenes by subsidizing clean research, this starts making clean technologies better and better over time. As they become sufficiently better and thus competitive with dirty technologies, the tables turn. Now private incentives that previously directed everybody to invest in and do research for dirty technologies start encouraging the advancement of clean technologies.

Perhaps surprisingly, the government does not even need to intervene forever. Temporary (though not short-term) interventions are sufficient to redirect technological change towards clean technologies and slow down adverse climate change.

What about carbon taxes? Carbon taxes would do the same also, but interestingly they are not by themselves sufficient. Unless one is willing to have prohibitively high carbon taxes — enough not just to reduce carbon consumption today but to also change the future path of technological change — subsidies to clean research have an important role. And typically it would be very costly to have such high levels of carbon taxes anyway.

So bringing Ehrlich’s concern about the adverse implications of economic growth together with Simon’s insight that endogenous technology is a powerful force leads to new and somewhat hopeful insights.

But here’s the catch. Will governments actually do it? Will they choose the right levels of subsidies to clean research and carbon taxes to slow down and even stop climate change? Or will they just stick to business-as-usual until it’s too late? That brings us to our next topic: the politics of technology.

Daron Acemoglu is the Killian Professor of Economics at MIT. In 2005 he received the John Bates Clark Medal awarded to economists under forty judged to have made the most significant contribution to economic thought and knowledge.

James A. Robinson, a political scientist and an economist, is the David Florence Professor of Government at Harvard University. A world-renowned expert on Latin America and Africa, he is currently conducting research in the Democratic Republic of the Congo, Sierra Leone, Haiti and in Colombia where he has taught for many years during the summer at the University of the Andes in Bogotá.

Acemoglu and Robinson are co-authors of Why Nations Fail. This post originally appeared on their blog.